Foreign accounts receivable present some additional challenges to a business that are not present with domestic-based customers.
It is harder for a business to pursue any overdue amounts from a business in another country with a different legal system. One option for a business is to simply trust the foreign customer to pay within the stated credit period without demanding additional security, a method known as ‘open account’. This option means the business faces a level of non-payment risk that some businesses may find unacceptable.
Reducing investment in foreign accounts receivable
A company can reduce its investment in foreign accounts receivable by asking for full or part payment in advance of supplying goods. However this may be resisted by consumers, particularly if competitors do not ask for payment up front.
Another approach is for the seller (exporter) to arrange for a bank to give cash for foreign accounts receivable, sooner than the seller would normally receive payment.
Forfaiting
One method of doing this is forfaiting. Forfaiting involves the purchase of foreign accounts receivable from the seller by a forfaiter. The forfaiter takes on all of the credit risk from the transaction (without recourse) and therefore the forfaiter purchases the receivables from the seller at a discount. The purchased receivables become a form of debt instrument (such as bills of exchange) which can be sold on the money market.
The non-recourse side of the transaction makes this an attractive arrangement for businesses, but as a result the cost of forfaiting is relatively high.
Forfaiting is usually available for large receivable amounts (over $250,000) and also is only for major convertible currencies. It is usually only available for medium-term or longer transactions.
Letter of credit
This is a further way of reducing the investment in foreign accounts receivable and can give a business a risk-free method of securing payment for goods or services.
There are a number of steps in arranging a letter of credit:
- Both parties set the terms for the sale of goods or services
- The purchaser (importer) requests their bank to issue a letter of credit in favour of the seller (exporter)
- The letter of credit is issued to the seller’s bank, guaranteeing payment to the seller once the conditions specified in the letter have been complied with. Typically the conditions relate to presenting shipping documentation and dispatching the goods before a certain date
- The goods are dispatched to the customer and the shipping documentation is sent to the purchaser’s bank
- The bank then issues a banker’s acceptance
- The seller can either hold the banker’s acceptance until maturity or sell it on the money market at a discounted value
As can be seen from the above process, letters of credit take up a significant amount of time and therefore are slow to arrange and must be in place before the sale occurs. The use of letters of credit may be considered necessary if there is a high level of non-payment risk.
Customers with a poor or no credit history may not be able to obtain a letter of credit from their own bank. Letters of credit are costly to customers and also restrict their flexibility: if they are short of cash when the payment to the bank is due, the commitment under the letter of credit means that the payment must be made.
Collection under a letter of credit depends on the conditions in the letter being fulfilled. Collection only occurs if the seller presents exactly the documents stated in the conditions. This means that letters of credit provide protection to both the purchaser and the seller. However, the seller will not be able to claim payment if, for example, goods have been sent by air but the letter of credit stated that shipping documents were required.
Countertrading
In a countertrade arrangement, goods or services are exchanged for other goods or services instead of for cash.
The benefits of countertrading include the fact that it facilitates conservation of foreign currency and can help a business enter foreign markets that it may not otherwise be able to.
The main disadvantage of countertrading is that the value of the goods or services received in exchange may be uncertain, especially if the goods being exchanged experience price volatility. Other disadvantages of countertrade include complex negotiations and logistical issues, particularly if a countertrade deal involves more than two parties.
Export credit insurance
Export credit insurance protects a business against the risk of non-payment by a foreign customer. Exporters can protect their foreign accounts receivable against a number of risks which could result in non-payment. Export credit insurance usually insures the seller against commercial risks, such as insolvency of the purchaser or slow payment, and also insures against certain political risks, for example war, riots, and revolution which could result in non-payment. It can also protect against currency inconvertibility and changes in import or export regulations.
Export credit insurance therefore helps reduce the risk of non-payment, but its’ disadvantages include the relatively high cost of premiums and the fact that the insurance does not typically cover 100% of the value of the foreign sales.
Export factoring
An export factor provides the same functions in relation to foreign accounts receivable as a factor covering domestic accounts receivable and therefore can help with the cash flow of a business. However, export factoring can be more costly than export credit insurance and it may not be available for all countries, particularly developing countries.
Other considerations
The purchaser may be able to get a local bank to guarantee payment to the exporter, but this may only be suitable in an arrangement where the purchaser has no power over the exporter.
General policies for foreign accounts receivable
None of the methods detailed above would allow the selling company to escape from the basic fact that credit should only be given to customers who are creditworthy.
A seller should insist that any payment is made in a convertible currency and in a form which the customer’s authorities will permit to become effective as a remittance to the seller. This may mean, for example, that the sale will be subject to clearance under exchange controls or any import regulations.
Written by a member of the Financial Management examining team